Indian Financial System - LPU Distance Education (LPUDE)...Unit 7: Depositories and Custodians 117 Unit 8: Financial Institutions 140 Unit 9: Commercial Banking Services 183 Unit 10:

Edited by: Dr. Rupesh Roshan Singh

INDIAN FINANCIAL SYSTEMEdited By

Dr. Rupesh Roshan Singh

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forLovely Professional University

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SYLLABUS

Indian Financial SystemObjectives: To analyze the role of a financial system in the development of an economy by understanding various constituentsof a country’s financial system and debate on whether and how each of these constituents should work together to have theright influence on the economy. Moreover, to understand the rules and regulations that governs the Indian financial markets,along with the steps taken by regulators to ensure stability.

Sr. No. Description

1. Indian Financial System: Introduction, components, key elements, functions, nature and role of financial system and financial instruments.

2. Financial Market Reforms: Context, need and objectives; major reforms after 1991.

3. Financial Markets: Money market in India; nature, instruments, types, players, location, functioning and participation.

4. Indian Capital Market: Introduction, structure, functions and role.

5. Primary Market: Introduction, Book building, online IPOs, Green-shoe option.

6. Secondary Market: Introduction, stock exchanges, Listing of securities, trading and settlement and role of NSCCL.

7. Depositories and Custodians: Depository system, DMAT, NSDL,CDSL, custodians, the Stock Holding Corporation of India Ltd.

8. Financial Institutions: Banking and Non Banking Financial Institution, Development Financial Institution (including RRBs).

9. Introduction to Financial Services: Factoring, Mutual Funds, Venture capital, Insurance services, Commercial banking services, Merchant banking, Leasing credit rating and Consumer Finance.

10. Financial Regulations: Regulation of Financial Markets and Institutions, Regulatory Frame work; Securities and Exchange Board of India and Reserve Bank of India.

Sr. No. Description

1 Indian Financial System: Introduction, components, key elements, functions, nature and role of financial system and financial instruments.

2 Financial Market Reforms: context, need and objectives; major reforms after 1991.

3 Financial Markets: money market in India; nature and types of instruments.

4 Indian Capital Market: Introduction, structure, functions and role.

5 Primary Market: Introduction, Book building process and role in economic development.

6 Secondary Market: Introduction, stock exchanges, Listing of securities, Depository system and DMAT.

7 Financial Institutions: Banking and Non Banking Financial Institution, Development Financial Institution (including RRB’s)

8. Mutual Fund: Introduction, types, Net asset Value, organization of mutual funds, SEBI guidelines.

9. Introduction to Financial Services: Factoring, Venture capital, Commercial banking services, Merchant banking, Consumer Finance.

10. Financial Regulations: Regulation of Financial Markets and Institutions, Regulatory Frame work; Securities Exchange Board of India and Reserve Bank of India, IRDA.

DCOM304

DCOM503 Indian Financial System

Indian Financial System

CONTENT

Unit 1: Indian Financial System

Rupesh Roshan Singh, Lovely Professional University

1

Unit 2: Financial Market Reforms


16

Unit 3: Financial Markets


30

Unit 4: Indian Capital Market


50

Unit 5: Primary Market


73

Unit 6: Secondary Market


97

Unit 7: Depositories and Custodians


117

Unit 8; Financial Institutions

Mahesh Kumar Sarva, Lovely Professional University

140

Unit 9: Commercial Banking Services


183

Unit 10: Credit Rating and Consumer Finance


205

Unit 11: Leasing and Factoring


226

Unit 12: Merchant Banking and Venture Capital


241

Unit 13: Mutual Funds and Insurance Services


256

Unit 14: Financial Regulations


290

LOVELY PROFESSIONAL UNIVERSITY 1


NotesUnit 1: Indian Financial System

CONTENTS

Objectives

Introduction

1.1 Components/Key Elements of Indian Financial System

1.2 Functions of Financial System

1.2.1 Linking Surplus and Deficit Spending Units

1.2.2 Providing Payment System

1.2.3 Managing Risks

1.2.4 Price Information

1.3 Nature and Role of Financial System

1.4 Nature and Role of Financial Instruments

1.5 Summary

1.6 Keywords

1.7 Review Questions

1.8 Further Readings

Objectives

After studying this unit, you should be able to:

Learn the concept of Indian financial system;

Explain the key elements related to Indian financial system;

Discuss the nature and functions of Indian financial system;

Understand role of financial system and financial instruments;

Understand components of Indian financial system.

Introduction

The financial system or the financial sector of any country consists of (a) specialized and non-specialised financial institutions (b) organized and unorganized financial markets and (c) financialinstruments and services which facilitate transfer of funds. Procedures and practices adopted inthe markets and financial interrelationships are also parts of the system. The financial system isconcerned about money, credit, and finance-the terms intimately related, somewhat differentfrom each other. Money refers to the returned medium of exchange or means of payment. Creditor loan is a sum of money to be returned normally with interest; it refers to a debt of economicunit. Finance is monetary resources comprising debt and ownership funds of the state, companyor person. Figure 1.1 shows a typical structure of financial system in any economy.


2 LOVELY PROFESSIONAL UNIVERSITY


Notes Figure 1.1 Overview of Financial System

Financial System

Savings Finance

Economic Growth

Investment

Capital Formation

1.1 Components/Key Elements of Indian Financial System

The financial system consists of the Central Bank, as the apex financial institution, other regulatoryauthorities, financial institutions, markets, instruments, a payment and settlement system, alegal framework and regulations. The financial system carries out the vital financialintermediation function of borrowing from surplus units and lending to deficit units. The legalframework and regulators are needed to monitor and regulate the financial system. The paymentand settlement system is the mechanism through which transactions in the financial system arecleared and settled.

Figure 1.2: Components of a Financial System

Financial System

Financial Intermediaries

Primary Market

Financial MarketsFinancial Assets/Instruments

Secondary Market

Credit MarketForex Market Money MarketCapital Market

Capital Market Instruments Hybrid InstrumentsMoney Market Instruments

Regulatory Authorities

Financial Institutions



Notes Financial Markets

Financial Instruments

Payment and Settlement Infrastructure

Let us get introduced to them one by one.

Regulatory Authorities

The main component of any financial system is the regulatory system it has. In any economy,the financial system is regulated by the central banking authority of that country. In India, thecentral bank is named as the Reserve Bank of India.

The Reserve Bank of India

The regulation and supervision of banking institutions is mainly governed by the CompaniesAct, 1956, Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980, Bankers'Books Evidence Act, Banking Secrecy Act and Negotiable Instruments Act, 1881

The regulation and supervision of finance companies is done by the Banking Regulation Act,1949 which governs the financial sector.

Individual Institutions are regulated by Acts like:

State Bank of India Act, 1954

The Industrial Development Bank (Transfer of Undertaking and Repeal) Act, 2003

The Industrial Finance Corporation (Transfer of Undertaking and Repeal) Act, 1993

National Bank for Agriculture and Rural Development Act

National Housing Bank Act

Deposit Insurance and Credit Guarantee Corporation Act

Securities and Exchange Board of India

The Securities and Exchange Board of India was established on April 12, 1992 in accordance withthe provisions of the Securities and Exchange Board of India Act, 1992 to protect the interests ofinvestors in securities and to promote the development of, and to regulate the securities marketand for matters connected therewith or incidental thereto.

Insurance Regulatory and Development Authority

Insurance Regulatory and Development Authority regulates and supervises the insuranceindustry - insurance companies and their agents and insurance brokers to protect the interests ofthe policyholders, to regulate, promote and ensure orderly growth of the insurance industryand for matters connected therewith or incidental thereto.

Financial Institutions

The financial system consists of many financial institutions. While most of them are regulatedby the Reserve Bank, there are some which it manages just indirectly.



Notes Institutions Regulated by the Reserve Bank of India

The institutions regulated by the RBI are:

Nationalised Commercial Banks

Specialised Banks

Registered Finance Companies

Registered Finance Leasing Establishments

Micro-Finance Institutions.

Institutions Not Regulated by the Reserve Bank of India

Certain financial institutions are not regulated by the Reserve Bank of India. These includesecurities firms, investment banks and mutual funds which come under the purview of the SEBI,Insurance Companies and Insurance Brokers which are regulated by the IRDA, etc.

Financial Markets

The Financial Market, which is the market for credit and capital, can be divided into the MoneyMarket and the Capital Market. The Money Market is the market for short-term interest- bearingassets.

Example:

1. Treasury bills

2. Commercial paper

3. Certificates of deposits

The major task of the Money Market is to facilitate the liquidity management in the economy.The Capital Market is the market for trading in medium – long term assets.

Example:

1. Treasury bonds

2. Private debt securities (bonds and debentures)

3. Equities (shares)

The main purpose of the Capital Market is to facilitate the raising of long-term funds.

Did u know? The main issuers in the

1. Money Market are the Government, banks and private companies, while the maininvestors are banks, insurance companies and pension and provident funds.

2. Capital Market are the Government, banks and private companies, while the maininvestors are pension and provident funds and insurance companies.

The Financial Market can be also be classified according to instruments, such as the debt marketand the equity market. The debt market is also known as the Fixed Income Securities Market andits segments are the Government Securities Market (Treasury bills and bonds) and the Private



NotesDebt Securities Market (commercial paper, private bonds and debentures). Another distinctioncan also be drawn between primary and secondary markets. The Primary Market is the marketfor new issues of shares and debt securities, while the Secondary Market is the market in whichexisting securities are traded.

The Reserve Bank of India through its conduct of monetary policy influences the differentsegments of the Financial Market in varying degrees. The Reserve Bank's policy interest rateshave the greatest impact on a segment of the Money Market called the inter-bank call moneymarket and a segment of the Fixed Income Securities Market, i.e. the Government SecuritiesMarket.

Financial Instruments

The main financial instruments can be categorized as under:

Deposits

Deposits are sums of money placed with a financial institution, for credit to a customer's account.There are three types of deposits - demand deposits, savings deposits and fixed or time deposits.

Loans

A loan is a specified sum of money provided by a lender, usually a financial institution, to aborrower on condition that it is repaid, either in instalments or all at once, on agreed dates andat an agreed rate of interest. In most cases, financial institutions require some form of securityfor loans.

Treasury Bills and Bonds

Treasury bills are government securities that have a maturity period of up to one year. Treasurybills are issued by the central monetary authority (the RBI), on behalf of the Government ofIndia. Treasury bills are issued in maturities of 91 days, 182 days and 364 days.

1.2 Functions of Financial System

A resilient and robust financial system is an adjunct to economic and industrial development ofa country because of the following critical functions that it performs.

1.2.1 Linking Surplus and Deficit Spending Units

A financial system facilitates transfer of funds from Surplus Spending Units (SSUs) to deficitspending units (DSUs) by providing means and mechanism to link the two groups. Surplusspending units, according to Goldsmith, 10 are those who have surplus of income overexpenditure for a given period. Households are the main type of surplus units. Business enterprisesand the government as well as foreigners and their governments also find themselves withexcess funds. Deficit spending units represent those whose expenditures for the period exceedreceipts. The most important deficit spending units are businesses, local and state governmentsand sometimes foreigners.

The financial system seeks to funnel funds from SSUs to DSUs in two basic ways: (i) Directfinancing and (ii) Indirect financing.

1. Direct Financing: In the direct financing route, DSUs issue financial claims on themselvesand sell them for funds to SSUs. The SSUs hold the financial claims in their portfolios on



Notes interest bearing assets. The claims issued by the DSUs are called direct claims and aretypically sold in financial markets. For example, if Tata Motors needs to borrow money tofund building a car manufacturing plant, it might borrow the money from savers byselling the bonds, a debt security that promises to make payment periodically for a specifiedperiod of time. Direct financing allows SSUs an outlet for their savings, which provides anexpected return and DSUs no longer needs to defer current consumption or promisinginvestment opportunities for lack of funds. However, one problem involved in directfinancing is that DSUs must scout SSUs that want primary claims with precisely thecharacteristics they can and are willing to sell. To aid in the search process there exists anumber of market specialists such brokers who act purely as 'matchmakers' between SSUsand DSUs and charge a commission for their services. Dealers also provide search servicesand make markets in securities by maintaining an inventory from which they buy and sellfor profit. They derive their income from providing search services and from the spreadearned on the buying and selling price of securities held in inventory. Another marketspecialist is the underwriter who helps DSUs bring their financial claims to market.Underwriters primarily perform risk bearing function. They buy the entire block ofsecurities to be issued by a DSU at a guaranteed price and then resell the securities toindividual investors. Income of the underwriters is the spread between the fixed pricepaid for securities and the price at which they are resold in the open market. The bottomhalf of Figure 1.3 illustrates the flow of funds from SSUs to DSUs by way of direct financing.

Figure 1.3: Flow of Money in Indian Financial System

IndividualsBrokersDealersUnderwriters

Direct Finance

Surplus Spending Units1. Households2. Business Firms3. Government4. Foreigners

Indirect Finance

Financial Intermediaries

FinancialMarkets

Funds

Fund

s

Surplus Spending Units1. Households2. Business Firms3. Household4. Foreigners

Funds Funds

Funds

2. Indirect Financing: Another route to transfer funds from SSUs to DSUs is indirect financing.In indirect financing, financial intermediaries such as banks, insurance companies, pensionfunds, etc., are involved. Indirect financing has emerged to overcome the problemsinvolved in direct financing. For direct financing to take place, the DSUs must be willingto issue a security with a denomination, maturity and other security characteristics thatsuit the desires of the SSUs. So long as their needs are not satisfied simultaneously, therewill hardly be any transfer of funds. Financial intermediaries intervene in the process oftransfer of funds. They buy securities with one set of characteristics (i.e., terms to maturity,denomination) from DSUs and transform them into indirect securities with a different setof features which they sell to the SSUs. This process of transformation is called



Notesintermediation and institutions associated with this process are called financialintermediaries or financial institutions. The top half of Figure 1.3 figures out the flow ofmoney through process of intermediation. Besides directing the pooled resources intoproductive outlets and facilitating the efficient life cycle allocation of physical capital inits most productive use in the business sector, the financial system makes possibleefficacious separation of ownership from management. This, in turn, enables the efficientspecialisations in production according to the principle of comparative advantage.

1.2.2 Providing Payment System

A financial system provides for effective system of payment for personal, business andgovernment transactions through array of financial instruments and intermediaries.

1.2.3 Managing Risks

A well-developed, smooth-functioning financial system offers a wide variety of financialinstruments that enable economic agents to pool, price and exchange risk. It provides adequatemechanism for risk-pooling and risk-sharing for both households and business firms. Thesemechanisms are built in hedging, diversification and insurance. While hedging is a technique tomove from a risky asset to riskless assets, diversification provides for pooling and subdividingrisks. Insurance enables the insured to retain the economic benefits of ownership while layingoff the possible losses.

1.2.4 Price Information

Besides facilitating transfer of funds from savers to investors, financial system provides necessaryinformation that plays significant role in coordinating decentralised decision-making.Information about existing interest rates and securities not only enable individuals in makingtheir saving and investment decisions but also aid the managers of business enterprises indeciding about choice of investment projects and funding thereof.

Self Assessment

Fill in the blanks:

1. A well developed …………………….. provides adequate mechanism for risk-pooling andrisk-sharing for both households and business firms.

2. …………………….. are government securities that have a maturity period of up to oneyear.

3. The …………………….. through its conduct of monetary policy influences the differentsegments of the Financial Market in varying degrees.

4. …………………….. intervene in the process of transfer of funds.

5. …………………….. primarily perform risk bearing function.

1.3 Nature and Role of Financial System

1. The price in financial markets is known as "rate of interest". Under conditions of perfectcompetition, the equality between total expected demand for funds and total plannedsupply of funds determines the equilibrium rate of interest.

2. The intervention between authorities in the form of administering interest rates results inexcess demand or excess supply of funds, which in turn requires the official policy of directallocation of financial resources.



Notes 3. The supply of funds depends on aggregate savings and credit creation by the bankingsystem, while the need for funds depends upon demand for investment, consumer durables,housing and so on.

4. The functions of a financial system are to establish a bridge between savers and investorsand thereby encourage savings and investment, provide finance in anticipation of savings,enlarge markets over space and time and allocate financial resources efficiently for sociallydesirable and productive purposes. The ultimate goal of the financial system is to acceleratethe rate of economic development.

5. Deficient financial markets are characterized by the absence of information-based game,by correct evaluation of assets, by maximization of convenience and minimization oftransaction costs and maximization of marginal efficiency of capital.

6. In reality, the contribution of financial system to growth is highly constrained because itdoes not work efficiently and capital is not the most important barrier to growth. The roleof finance in development is believed to be secondary by many experts.

7. A framework to evaluate the working of any financial sector must include economic,commercial as well as social and ethical criteria.

8. Financial innovations refer to wide ranging changes in the financial system. Theintroduction of new financial institutions, markets, instruments, services, technology,organization and so on.

9. Financial engineering connotes skillful development and use of new financial technologycreates solutions and tools to cope with financial changes. It involves construction,designing, re-construction of innovative financial instruments, institutions and processesto reduce risk and to maximize profits quickly.

10. Financial revolution means that the magnitude, speed and spread of changes in the financialsector are simply phenomenal.

11. The markets that attract funds in large volume and from all types of investors are knownas broad financial markets.

12. The markets which provide opportunities for sufficient orders at fine rates below andabove the market price are called deep financial markets. The underdeveloped marketsdue to government regulations and controls are termed as swallow financial markets.

13. Financial repression exists when the regularity polices of the government distort interestrates, discourage savings, reduce investment and misallocate resources.

1.4 Nature and Role of Financial Instruments

Financial systems deal in financial services and claims and are many and varied in character.This is so because of the diversity of motives behind borrowing and lending. The generalcharacteristics of these claims are given below:

Financial Assets

An asset, broadly speaking, is any possession that has value in an exchange. An asset may betangible or intangible. A tangible asset is one whose value depends on particular physicalproperties, such as buildings, land, machinery, etc. An intangible asset, by contrast, representslegal claims to some future benefit. The intangible value does not bear relation to the form,physical or otherwise, in which these claims are recorded. Financial assets, also known as



Notesfinancial instruments or securities, are intangible assets inasmuch as their value is a claim tofuture cash.

Equity shares, preference shares, corporate bonds, government security are examples of financialassets. The entity that offers future cash flows is called the issuer of the financial assets and theowner of the financial assets is called the investor.

Financial assets exist in an economy because the savings of various individuals, business firms,and governments during a period of time differ from their investment in real assets (physicalassets). If savings equaled investment in real assets for all economic units in an economy over aperiod of time, there would be no external financing and no financial assets. A financial asset iscreated only when the investment of an economic unit in real assets exceeds its savings, and itfinances this excess by borrowing or issuing equity securities. Of course, another economic unitmust be willing to lend. In the economy as a whole, savings-surplus economic units providefunds to savings deficit units and this exchange of funds is evidenced by pieces of paperrepresenting a financial asset to the holder and a financial liability to the issuer.

Wide range of financial instruments with varying maturity denominations, claims to incomeand assets and controlling power are traded in financial markets so as to cater to the diverseneeds of both the supplier of funds and those who need them. Thus, there may be short-term aswell as long-term financial assets. Among short-term instruments, Commercial bills, Treasurybills, Negotiable certificates of deposits, Commercial paper, Eurodollars are the importantones.

Commercial Bills represent an important short-term financial instrument that arises out ofcommercial transactions. When a buyer is unable to make the payment immediately, the sellermay draw a bill upon him payable after a certain period. The buyer accepts the bills and returnsto the seller who either retains till the due date or gets it discounted from some bank to get cash.

Treasury Bills are the most popular instrument used by the government to raise funds. They aredirect obligations of the government and are almost risk free. They have maturities rangingfrom three months to one year. Financial institutions, corporations and individuals buy thesesecurities from liquidity and safety of principal.

Notes The yields on Treasury bills and bonds are market determined and the market isboth active and liquid.

Negotiable Certificate of Deposit (CD) is a special type of time deposit of a commercial bank.Negotiable CDs typically have maturities of one to twelve months and are issued indenominations ranging from $1,00,000 to $1million. CDs are sold only by the largest and mostcreditable banks and have a very low default risk.

A Commercial Paper is the unsecured promissory notes with a fixed maturity, usually, betweenseven days and three months, issued in bearer form and on a discount basis. Commercial paperis typically issued by corporations and finance companies. The default risk of commercial paperis quite low because only well-established business firms can sell it. It is marketed through ahandful of dealers or it may be issued directly to the issuing firm.

Eurodollars are a relatively new instrument. They are nothing more than U.S. dollar denominatedliabilities of foreign banks or offices of U.S. banks located in foreign countries. Eurodollars aretraded in Europe. American firms and banks can borrow in this market. Business firms usuallyborrow to finance their international operations. Banks use Eurodollars to make domestic loansand investment. The loans are generally from one month to six months, and transaction sizes aretypically $10 million.



Notes Besides, long-term financial instruments are employed to procure funds for longer period oftime. Among various instruments, equity shares and bonds are the most popular.

Equity Shares represent the owner's equity. The holders of equity shares are residual ownerswho have unrestricted claim on income and assets of the firm and who possess the voting powerin the firm.

Bonds are a long-term promissory notes with maturities ranging from 5 to 30 years. Holders ofbonds have priority of claim to income over equity shareholders and have legal recourse forenforcing their rights. Further, the bondholders' claim to income is fixed and certain and theborrowing firm is under a legal obligation to pay it in cash regardless of the level of earnings ofthe firm. They have also priority over shareholders in respect of their claim on assets. Bondsmay be secured by mortgages and other assets of the firm or they may be unsecured. Unsecuredbonds are also known as debentures and are generally issued by firms of the highest creditquality. Corporate bonds are usually bought by institutions not requiring high liquidity oftheir financial assets.

Broadly speaking, financial assets perform two principal economic functions. One such functionis to funnel funds from those who have surplus of income over expenditures to those who needfunds to invest in tangible assets. Another function is reallocation of risk. Financial assets seekto transfer funds in such a manner as to redistribute the unavoidable risk associated with thecash flow generated by tangible assets among those seeking and those supplying the funds. Thefollowing illustration will explain these functions.

Example:

1. A, a retired executive, has got a license to manufacture TV sets. He estimated that ̀ 5 croreswill be required to set up the plant and install machinery for the purpose.

2. A has lifetime savings of ` 1 crore. He does not want to invest it in plant and machinery.

3. B has recently inherited ` 3.5 crores. He plans to use ` 50 lakhs on some jewellery andinvest the remaining ` 3 crores.

4. C, a chartered accountant, has savings after taxes of ` 2.5 crores. He desires to spend ` 50lakhs to install a computer system and invest the balance ` 2 crores.

These persons met at a social gathering. In course of their meeting, they discussed their futureplans and arrived at a deal. A agrees to invest ` 50 lakhs of his savings in the business and sellsa 50% interest to B for ̀ 3.5 crore. C agrees to lend A ̀ 1 crore for 5 years at an interest rate of 15%p.a. A will be responsible for operating the business without the assistance of B and C. A now has` 5 crores to manufacture TV sets.

In the above meeting, two distinct financial claims came out. The first is an equity instrumentissued by A to B for ` 3.5 crore. The other is debt instrument issued by A and purchased by C for` 1 crore. Thus, the two financial assets allowed funds to invest to A, who needed funds to investin tangible assets. This transfer of funds is the first economic function of financial assets.

In this process of transfer of funds, it was noted that A was loath to invest his life savings of `1crore in the venture and wanted to transfer part of that risk which he did by selling a financialasset to B giving him a financial claim equal to one-half of the cash flow from the business. Hefurther managed to procure an additional fund from C, who is not keen to share the risk of thebusiness, by way of an obligation requiring payment of a fixed cash flow, irrespective of theoutcome of the venture. Thus, this shifting of risk is the second economic function of financialassets.



Notes

Task Find out the latest issue in secondary market and check the following:

Underwriter

Lead bank

Investment banker

Self Assessment

Fill in the blanks:

6. ………………….are a long-term promissory notes with maturities ranging from 5 to 30years.

7. …………………………..is created only when the investment of an economic unit in realassets exceeds its savings, and it finances this excess by borrowing or issuing equitysecurities.

8. ………………………….represent an important short-term financial instrument that arisesout of commercial transactions.

9. …………………………….is the unsecured promissory notes with a fixed maturity, usually,between seven days and three months, issued in bearer form and on a discount basis.

10. ………………………are usually bought by institutions not requiring high liquidity oftheir financial assets.

11. The commercial banking sector comprises of public sector banks, private banks and………………….

12. RBI also regulates foreign exchange under the …………………………….Act.

13. ………………………………………………… is the regulatory authority in the insurancesector under the Insurance Development and Regulatory Authority Act, 1999.

14. ………………………is one whose value depends on particular physical properties, such asbuildings, land, machinery, etc.

15. Deposits are sums of money placed with a financial institution, for ……………to a customer'saccount.

1.5 Summary

The financial system is the system that allows the transfer of money between savers andborrowers. It is a set of complex and closely interconnected financial institutions, markets,instruments, services, practices, and transactions.

India has a financial system that is regulated by independent regulators in the sectors ofbanking, insurance, capital markets, competition and various services sectors.

In a number of sectors Government plays the role of regulator.

RBI is regulator for financial and banking system, formulates monetary policy andprescribes exchange control norms.

The commercial banking sector comprises of public sector banks, private banks and foreignbanks.



Notes The public sector banks comprise the 'State Bank of India' and its seven associate banksand nineteen other banks owned by the government and account for almost three fourthof the banking sector.

India has a two-tier structure of financial institutions with thirteen all India financialinstitutions and forty-six institutions at the state level.

All India financial institutions comprise term-lending institutions, specialized institutionsand investment institutions, including in insurance.

State level institutions comprise of State Financial Institutions and State IndustrialDevelopment Corporations providing project finance, equipment leasing, corporate loans,short-term loans and bill discounting facilities to corporate.

Non-banking Financial Institutions provide loans and hire-purchase finance, mostly forretail assets and are regulated by RBI.

RBI also regulates foreign exchange under the Foreign Exchange Management Act (FEMA).

SEBI) established under the Securities and Exchange aboard of India Act, 1992 is theregulatory authority for capital markets in India.

Insurance sector in India has been traditionally dominated by state owned Life InsuranceCorporation and General Insurance Corporation and its four subsidiaries.

Insurance Development and Regulatory Authority (IRDA) is the regulatory authority inthe insurance sector under the Insurance Development and Regulatory Authority Act,1999.

1.6 Keywords

Commercial Paper: Are the unsecured promissory notes with a fixed maturity, usually, betweenseven days and three months, issued in bearer form and on a discount basis.

Deposits: Are sums of money placed with a financial institution, for credit to a customer'saccount.

Intangible Asset: By contrast, represents legal claims to some future benefit.

Loan: Loan is a specified sum of money provided by a lender, usually a financial institution, toa borrower on condition that it is repaid, either in instalments or all at once, on agreed dates andat an agreed rate of interest.

Tangible Asset: Is one whose value depends on particular physical properties, such as buildings,land, machinery, etc.

Treasury Bills: Are government securities that have a maturity period of up to one year.


1. What is financial system? Discuss its salient functions.

2. Discuss, in brief, the structure of financial system.

3. Write a short note on the role of financial instruments in the Indian financial system.

4. "A financial system facilitates transfer of funds from Surplus Spending Units (SSUs) todeficit spending units (DSUs) by providing means and mechanism to link the two groups."Comment.



Notes5. "Negotiable Certificate of Deposit (CD) is a special type of time deposit of a commercialbank." In the light of the statement discuss the importance of Certificate of deposits.

6. Write a brief note on the nature of Indian financial system.

7. What according to you is the role of Indian Financial system? Discuss in brief.

8. Highlight the major functions of Indian financial system.

9. "Commercial Bills represent an important short-term financial instrument that arises outof commercial transactions". Discuss

10. Throw light on the various constraints towards growth of Indian financial system?

Answers: Self Assessment

1. Financial System

2. Treasury bills

3. Reserve Bank of India

4. Financial intermediaries

5. Underwriters

6. Bonds

7. Financial asset

8. Commercial Bills

9. Commercial Paper

10. Corporate bonds

11. foreign banks

12. Foreign Exchange Management

13. Insurance Development and Regulatory Authority

14. Tangible asset

15. credit


Books G. M. Meier and R. E. Baldwin, Economic Development, Theory, History, Policy,John Wiley & Sons, INC, New York, 1957, p.2.

George Rosen, Industrial Change in India, Asia Publishing House, Bombay, 1959,p.1.

W. Arthur Lewis, The Theory of Economic Growth, George Allen & Unwin Ltd.,London, 1956, p11.

Ragnar Nurkse, Problems of Capital Formation in Underdeveloped Countries,Basil Blackwell, Oxford, 1955, p.2.

Ibid.



Notes

Online links www.bis.org

This website provides information about world financial markets andinternational debt outstanding.

www.federalreserve.gov

This website provides information about financial markets securities holdings.

www.thebanker.com

This website provides information about the largest banks of the world

Case Study Should Financial Systems be Rule-based?

After evaluating the pitfalls and advantages of both the systems, there is a viewemerging that the financial system should be more rules-based.The recent global meltdown has proved one thing: Neither a rules-based regulatory systemnor a principles-based regulatory system is a guarantee against bank failure. However,after evaluating the pitfalls and advantages of both the systems, there is a view emergingthat the financial system should be more rules-based; this is especially true in the UK.

In contrast, two committees set up in India – the Percy Mistry Committee (2007) and theRaghuram Rajan Committee (2008) – to look into financial sector reforms haverecommended that India's regulatory regime should move from rules-based to a principles-based one.

Principles-based regulation (PBR) implies moving away, wherever possible, fromdictating, through detailed prescriptive rules and supervisory actions, how firms shouldoperate their businesses. Rules-based regulation, it is pointed out, is too rigid andprescriptive, and often the regulator and the regulated adopt adversarial and antagonisticpostures. Some of the countries that follow principles-based regulatory systems are theUK, Australia, Canada and Ireland. Some of the leading countries whose regulatory regimeis based on rules are the US, Spain and India.

However, as noted in the Turner Review, banks in countries following either of thesystems have failed. For example, banks have failed in the US and the UK. So in a way,neither of the regulatory systems has proven to be robust. One way to draw lessons fromthe crisis would be to examine what countries such as India, Spain and Canada did right toinsulate their financial systems from succumbing to the global crisis.

Spanish Method

It would be worthwhile to examine the approaches of the various regulators to housing ormortgage finance. Spain, which follows a rules-based system, has a clearly spelt out mortgagerisk policy for its credit institutions. Banco De Espana (BE) lays down that lending policyof credit institutions for mortgage should take into account the repaying capacity of theborrowers and should not just be based on the collateral. BE also emphasises on theimportance of the loan to value (LTV) ratio. It cautions its credit institutions against beingtoo permissive about LTV as this typically increases the expected losses in a mortgageloan portfolio.

Contd...



NotesThe conservatism that insulated Spanish banks from crisis also played its role in keepingthe banking system healthy in Canada, which follows a principles-based system ofregulation. For example, mortgages with less than a 20 per cent down-payment have to beinsured, and most of the securitised mortgage market consists of Canada Mortgage Bonds,which carry a government guarantee. The Canadian central bank also did not allow creationof complex, synthetic securitised instruments involving Canadian mortgage assets.

In India, the Reserve Bank of India (RBI) has strict rules regarding housing finance,specifying the risk weights to be attached to loans extended to borrowers. These riskweights vary according to the LTV ratios. The RBI also specifies the maximum sanctionedamount for LTV ratios as less than or equal to 75 per cent.

UK's System

In the UK, the Financial Services Authority (FSA) follows a principles-based regulation.However, in its proposed reforms for mortgage lending, it has categorically bannedcertain practices such as self-certified mortgages replacing it with those requiringverification of the income of the borrowers. It also now requires mortgage advisers to bepersonally accountable to the FSA.

Having realised that non-interventionist principles-based system need not always lead tothe desired regulatory outcome, there appears to be a distinct shift in the UK from a non-interventionist stance to a more intrusive one.

The Federal Reserve has also notified a revision in its Regulation (which implements theTruth in Lending Act and Home Ownership and Equity Protection Act), prohibitingcreditors from making higher-priced mortgage loans based on the "value of the consumer'scollateral without regard to the consumer's repayment ability".

Thus, in the case of the US and the UK, at least with respect to mortgage lending, the biasis in favour of a rules-based system. But is this desirable?

One of the biggest criticisms levelled against the rules-based system is that it stiflesinnovation by being too interfering. In contrast, a principles-based regulation is moreaccommodative to innovation because it is pliant and flexible. But, as the recent meltdownhas shown, while gains from financial innovation benefit a few, the losses affect a greaternumber through systemic instability. When it comes to a trade-off between profitabilityand financial stability, the choice is very clear. Financial stability creates conduciveatmosphere for profitability and for carrying out banking. Therefore, a rules-based systemclearly scores over a principles-based system.

A developing country like India has its own compulsions which make a rules-basedsystem better suited when it comes to meeting our development objectives. For example,with respect to financial inclusion, unless it is specifically laid down that banks must offerno-frills accounts to their customers with zero or minimum balance and also relax criteriafor identification and account opening, the goal of financial inclusion may not be achieved.

Also, there is nothing in the rules-based system that disallows innovation. If that were thecase, Indian banks wouldn't have been allowed to offer several products that they nowoffer. The pace of innovation would be slow but if it ensures financial stability for thesystem, the trade-off would be well worth it.

Question

Discuss the importance of rules and regulation in financial system.

Source: http://www.thehindubusinessline.in



Notes Unit 2: Financial Market Reforms

CONTENTS

Objectives

Introduction

2.1 New Issue Market during Pre-reform Period

2.1.1 An Overview

2.1.2 Security-wise New Issue Activity

2.2 New Issue Market during Post-reform Period

2.2.1 Measures to Bolster up New Issue Market

2.3 Developments in New Issue Market

2.3.1 Quantitative Dimension

2.3.2 Qualitative Dimension

2.3.3 Ownership Pattern of New Issues

2.4 Sectoral Pattern of New Issues

2.5 Mode of Distribution of New Issues

2.6 Summary

2.7 Keywords



Objectives

After studying this unit, you should be able to:

Understand need for reforms;

Understand the context and objectives of financial market reforms;

Understand new issue market during pre-reforms period;

Discuss the development in the new issue market;

Explain Mode of distribution in the new issue market.

Introduction

The new issue market in India is not as much developed in terms of quantity and quality ofactivities as also financial depth and sophistication as in the US, UK and European countries.Nevertheless, it has over a period time, grown spectacularly in tandem with scorching pace ofeconomic and industrial growth of the country and emerged as robust and resilient constituentof the financial market to cope with the competitive challenges across the economy. Dynamismin the new issue market in India, as perceptibly reflected in the volume of new issue activity, useof innovative instruments to garner funds, methods of distribution of securities, pricing ofissues and broadening of market base over a period of time, is because of inexorable policy




Notesinterventions, rapid industrialization of the country, path breaking technological developments,entry of financial institutions and foreign investors in the market, growing community of retailinvestors willing to take direct investment risks and strong support by Indian stock market.

As such, it would be appropriate to present a panoramic view of developments of Indian newissue market during the pre and post-reform period.

Coverage of Financial Sector Reforms

What constituents of the Financial Sector were covered by reforms? The components of thefinancial markets that were chosen for effecting measures under the reforms are:

1. Money Market

2. The Securities market.

Objective of Financial Sector Reforms by Government of India & RBI

To widen, deepen and integrate the different segments of financial sector, namely, the moneymarket, debt market (particularly Government securities) and foreign exchange market.

2.1 New Issue Market during Pre-reform Period

2.1.1 An Overview

The new issue market in India was in its infancy at the time of independence because of a host offactors.

Example: Low demand for long-term funds due to feeble industrial base and low savingrate, reliance of many foreign companies on the London capital market for garnering funds,predominance of managing agency system with its rampant malpractices in promotion,management and underwriting of new capital issues, indifferent attitude of Indian corporates inaccessing market for raising funds through shares and debentures and hazards of administeredinterest rate structure.

Even during the initial years of planning new issue activity remained subdued due to low levelof household savings, absence of investing attitude among the individuals, retarded industrialand infrastructural development, inadequate support from the stock market and financialinstitutions, absence of underwriting facilities, and above all, the government control, whichregulated everything from the size of the issue to its pricing and issuing of bonus shares.

Table 2.1: Amount of Issues During the First Plan to the Seventh Plan Period

Period Amount of issues

( In crore)` Period Amount of issues

( In crore)` First Plan (Yearly Average)

84.5 (16.9)

Fourth Plan (Yearly Average)

308.8 (61.8)

Second Plan (Yearly Average)

171.1 (34.2)

Fifth Plan (Yearly Average)

415.8 (83.2)

Third Plan (Yearly Average)

365.0 (73.0)

Sixth Plan (Yearly Average)

1090.80 (218.2)

Three Annual Plans (Yearly Average)

268.6 (89.9)

Seventh Plan (Yearly Average)

2793.0 (558.6)



Notes Table 2.1, exhibiting data regarding amount of issues during the First Plan to the Seventh Planperiod, shows that yearly average of the amount of new security floated in the market rangedbetween ` 17 crore and ` 83 crore during first plan period to fifth plan period. Phenomenalprogress was, however, recorded during Sixth and Seventh plan periods which witnessed surgein yearly average volume of new issue business to ` 218 crore and ` 559 crore, respectively. Thereasons attributable to this trend were establishment of considerably large number of newenterprises and expansion and modernization of a large number of existing undertakings leadingto phenomenal spurt in demand for capital, increasing facilities in respect of underwriting ofnew capital issues and marketing of securities, participation of national and state level financialinstitutions in new issue activity and above all existence of favorable investment climate in thecountry. The liberalization of industrial and new capital issue policies in 1984-95 and relaxationof norms relating to foreign investments and incentives given by the government had givenfillip to sustain the growth in the market.

2.1.2 Security-wise New Issue Activity

Table 2.2 exhibits information relating to security-pattern of issues floated by non-governmentpublic limited companies. It may be glanced from the table that equity shares predominated thenew issue activity in the country especially till the end of 1970s, accounting for nearly three-fourths of the new capital issues. The position was, however, reversed during 1981-90 when theshare of public debt floatation recorded a meteoric rise of over 66 percent. This was primarilydue to enabling policy of the government in 1984 regarding the issue of secured convertible aswell as non-convertible debentures by the Indian public limited and public sector companiesand introduction of a new instrument called Public Sector Bonds (PSBs) and formulation ofpolicy guidelines for the issue of such PSBs by the government. The Government of India furtherapproved in January 1989 a new instrument called Partly Convertible Debenture (PCD).

Table 2.2: Issues Floated by Non-government Public Limited Companies

Period Equity Shares

% Preference Shares

% Debentures

% Total

1951-60 67.9 13.7 15.4 100.0 1961-70 64.4 10.6 25.0 100.0 1971-80 75.2 5.6 19.2 100.0 1981-90 33.6 0.2 66.2 100.0

2.2 New Issue Market during Post-reform Period

2.2.1 Measures to Bolster up New Issue Market

In its endeavour to rev up new issue activity in India, the Government of India SEBI undertookthe following reformatory measures during the post-reform period:

1. Pursuance of the policy of deregulation and delicensing;

2. Repeal of capital issue (Control) Act, and abolition of office of Controller of Capital issuesin 1992;

3. Introduction of market-based pricing system;

4. Constitution of the SEBI to promote the development of the securities market and protectthe interests of investors in securities;

5. Constitution of OTC Exchange of India and establishment of National Stock Exchange of India;



Notes6. Permission to Indian companies to raise resources abroad through the issue of GlobalDepository Receipts (GDR) and Foreign Currency Convertible Bonds (FCCBs);

7. Disinvestments by the Government of India of its holdings in public sector undertakings;

8. Replacement of FERA by FEMA;

9. Opening up of the market for portfolio investments by FIIs and encouraging foreignprivate participation in financial services including stock broking;

10. Permitting entry of new institutions like merchant banks, leasing and hire purchasecompanies, and venture capital funds/companies;

11. Permitting commercial banks to raise equity share capital from the market;

12. Permitting public sector financial institutions to participate/underwrite debenture issuesof MRTP/FERA companies up to 5% of each issue of debentures;

13. Permitting introduction of innovative financial instruments such as warrants, cumulativeconvertible preference shares, non-voting shares, sweet equity shares, and a host of hybridbonds/debentures.

14. Permitting companies to issue Non-Convertible Debentures (NCDs') along with warrantsto qualified institutional buyers.

15. Making it mandatory on the part of promoters to disclose the details of shares held bythem in listed entities promoted by them.

16. According approval to the concept of "anchor investor" in public issues, whereby a personother than a promoter can be allocated as much as 30 percent of the portion reserved forqualified institutional buyers (usually 60 percent) in an issue through a bidding process.The minimum size of application for anchor investors would be ` 10 crore and theirmargin payable on application is 25 percent and the balance 75 percent to be paid within2 days of the date of closure of the public issue.

17. Simplifying regulatory framework for issuance and listing of non-convertible debtsecurities by an issuer company, public sector undertaking or statutory corporation.

Self Assessment

Fill in the blanks:

1. Govt. of India approved a new instrument, called ……………............, in 1989.

2. GDR stands for ……………............

3. FCCB stands forv

4. NCD is the abbreviation for ……………............

2.3 Developments in New Issue Market

Cumulative effect of the above, coupled with the surging economic growth and concomitantrise in household savings (about 30 percent) and increasing appetite of individual and institutionalinvestors for investment brought about cataclysmic change in landscape of the new issue marketand its related activities, heralding the emergence of matured and resilient market in the country,as is evident from the quantitative and qualitative dimensions of the new issue activity.

2.3.1 Quantitative Dimension

Table 2.3 shows that new issue market on the whole exhibited spectacular performance interms of garnering of resources through new issue floatation's.



Notes There is an almost eight fold increase from ` 1, 700 crore to over ` 13, 000 crore during theperiod 1990-91 to 1994-95, because of the floatation of a string of mega issues includingSBI which made the largest ever issue in the history of the capital market (2,502 crore in1993-94), also heralding the entry of banks into the capital market arena.

The other steps taken by the government to strengthen the market for government securitieswas through an upward revision in interest rates and the introduction of a system ofauction of securities and provision of refinancing facilities for these securities that gaveimpetus to the new issue activity in the country.

Table 2.3: Resources Mobilized through New Capital Issues

Period No. of issues Amount ( crore)`

Period No. of issues Amount ( crore)`

1990-91 141 1,704.35 2000-01 124 6,617.70 1991-92 196 1,898.25 2001-02 19 6,422.74 1992-93 528 6,251.83 2002-03 17 5,731.57 1993-94 770 13,443.19 2003-04 45 22,144.57 1994-95 1343 13,311.60 2004-05 59 25,506.34 1995-96 1428 11,822.18 2005-06 138 26,940.00 1996-97 753 11,686.56 2006-07 119 32,382.00 1997-98 62 3,061.22 2007-08 115 83,707.00 1998-99 32 7,910.14 2008-09 45 14,671.00 1999-2000 65 7,613.14

Sources: Prime Data, Business Standard and RBI Annual Reports

Because of economic and industrial recession, political instability, and the changing patternof household financial savings the new capital issues gradually declines in 1997-98 to` 3,061.22 crore.

The nature of the new issue market also changed with the bank on 'carry forward' sinceJanuary 1994 as also commencement of screen based trading at NSE and BSE.

Some signs of revival were seen 1998-99 terms of resource mobilization. Total resourcesmobilized through prospectus and rights issues more than doubled to ` 7,910.74 crorefrom ` 3,061.22 crore in 1997-98.

Despite a significant increase in the number of floatations there is a sharp decline in theprimary market in resource mobilization during 2000-01, Although resources raised byboth public and private sectors declined, the decline was much sharper in the case of theformer with PSUs and government companies remaining absent from the public issuesmarket for third consequent year. It is interesting to note that resources raised by banksand financial institutions after surging to ` 4,352 crore during 1996-97 continued to declinein the subsequent years touching an all time low of ` 1,472 crore in 2001. This is due topersistent depression in new issues market.

The sterling performance of the new issue market in India in recent years is the reflection ofeffectiveness of the measures initiated by the government/SEBI to develop the market andrestore confidence. Some of such factors are:

strong macroeconomic fundamentals and higher growth rate trajectory embarked uponby the Indian economy buoyancy in the secondary market

encouraging both issuers as well as investors to enter the primary market

countrywide enthusiasm in the community of entrepreneurs to enlarge and modernizemanufacturing capacities to meet domestic as well as foreign demand

higher rate of return on equity investments in the face of decline in interest rates ondeposits



Notes Increased savings rate among individuals as well as big corpuses of funds available withinsurance companies and mutual funds, and increase in the appetite of FIIs as well as retailinvestors also helped in stoking up demand for new issues.

2.3.2 Qualitative Dimension

Not only has there been quantum jump in new issue floatations, there has also been qualitativechange in new issue activity, as manifest from the following discussions:

Security Pattern of New Issues

From the table 2.4 given below, we can observe that:

Equity issues dominated new issue market, for about two-thirds of the total new issuefloatations

During the period 1981-82 to 1990-91, almost two-thirds of the total funds were raisedfrom the market through bonds and debentures while equity shares lost its sheen, accountingfor only 34 percent of the total.

Prominence of debenture as a financial instrument continued during the next decade. Barringtwo years 1994-96, the Indian new issue market remained overwhelmingly debt market.

The state of despondency witnessed in equity share market during 1981-82 to 1990-91waned during the post reform period of 1991-92 to 1996-97 when new equity issues of theorder of ` 56, 997 crore, out of the total issues of ̀ 98, 000 crore were offered in the market.

The free pricing era (post-CCI), led to the revival of equity shares. Several large companieswhich were reluctant to issue equity shares in CCI era (because of the forced underpricing ofissues under the prescribed CCI guidelines) found the freedom to issue and price equityissues as cheap option to garner resources. During 1994-95 when the primary market was inbuoyancy, equity issues accounted for 73% of the total resources mobilized during the year.

Table 2.4: Security-pattern of New issue Floatation byNon-government Public Limited Companies

( crore)` Period Equity Shares Preference Shares Debentures Total

1951-60 202 39 44 285 1961-70 462 77 188 727 1971-80 746 56 190 992 1981-82 to 90-91 7,857 40 15,459 23,356 1991-92 to 96-97 56,997 746 40,267 98,010 1997-98 to 02-03 10,405 206 15,152 25,763 2003-04 2,323 - 1352 3,675 2004-05 12,004 - 1478 13,482 2005-06 20,899 10 245 21,154 2006-07 29,756 - 847 30,603 2007-08 56,848 5,481 1309 63,638

Source: RBI, Annual Report on Currency and Finance for relevant years.

This robust growth of equity culture lasted for four years, i.e. from 1991-92 to 1994-95. Since1995, predominance of debt as a source of corporate financing was noticeable. Debt instrumentsaccounted for larger share of total funds raised from the market than equity shares because offollowing reasons:

raising of the ceiling rate of interest on debentures,

shorter redemption period of 7 years,



Notes allowing redemption premium up to 5% of the face value and allowing the company toissue non-convertible debentures to have a buy-back at par from any debenture holderwhose total holding does not exceed ̀ 40,000 crore and has held debentures for at least oneyear,

permitting FIIs to invest in government securities (which account for more than 60% ofthe debt market),

entry of profitable PSUs in new issue market with issues of bonds to mutual funds,commercial banks and other commercial institutions, permitting the public sector financialinstitutions to participate/underwrite debenture issues of MRTP/FERA up to 5% of eachissue of debentures and relaxation of debt-equity norms from 1:1 to 2:1.

A long period of lacklustre activity in equity issue market was arrested in 2003-04 when newequity issues floated surged to ` 2323 crore as against ` 460 crore in the previous year. Hightempo in the equity issue market tended to persist in the subsequent years so much so that fundsmobilized through floatation of 136 equity issues soared to ` 29,756 crore in 2006-07 accountingfor over 99% of the total resources raised during the year.

The main factors that contributed to the upsurge in new equity issues were:

robust economic and industrial health of the country

higher return on equity shares

buoyancy in the secondary market

increased enthusiasm among the investment community

higher saving rate and

participation of retail investors in the equity market, that have pumped in about ` 17,500-18,000 crore into the equities during 2006 as compared to ` 8000 crore in 2005.

However, retail investors' enthusiasm for equity offerings disappeared during 2008-09 becauseof their cautious approach and volatility in markets. Average subscription of retail investors toIPOs has dropped dramatically from 19 percent in 2004 to 3 percent in 2009. It is hoped that withrecovery of economy and market stability they will be more inclined to invest.

Also garnering of resources by Indian corporates from international capital markets throughADRs and GDRs. Thus, funds raised through Euro issues soared to ̀ 26,556 crore in 2007-08 from` 3,098 crore in 2003-04. Most of the Euro issues were made by private sector finance companies.

Size-wise New Issues

Another qualitative dimension of new issue market is size of the new issue. It may be notedfrom Table below that:

annual average absolute amount of fresh capital raised by non-government public limitedcompanies shot up significantly from ` 28.5 crore during 1951-60 to over ` 38,000 croreduring 2003-08, clearly indicating burgeoning expansion of new issue activity in Indiaduring the post-reform period.

In 1999-2000, the average size of IPOs was ` 100 crore which shot up to more than ` 700crore by 2005-06.

Also, the average size of issue, including listed as well as IPOs increased over five foldfrom ` 94 crore to 497 crore. Thus, companies came to the market with issues of large size.



Notes (` crore) Period Amount Period Amount

1951-1960 28.50 1991-92 to 1996-97 9737.2 1961-1970 72.80 1997-98 to 2002-03 6226.09 1971-1980 99.20 2003-2008 38035.98 1981-82 to 1990-91 2335.70 2008-2009 326.00

2.3.3 Ownership Pattern of New Issues

Table 2.5 reveals the chequered trend in relative share of public and private sectors in newsecurity offerings. However, the role of public sector in garnering public funds gained prominenceespecially after 1994-95 when public sector undertakings and financial institutions entered theprimary market with issues of bonds. In recent few years, private sector dominated the newmarket because of bullish state of the economy and secondary market and investors' growinginterest in equity issues of private enterprises.

It is interesting to observe that in both public and private sectors, banks and financial institutionsmobilized larger proportion of resources by public issues. For instance, they garnered almost 39percent of resources through public issues in 2007-08. The corresponding proportion was 52.0percent in 2004-05.

Table 2.5: Exhibits Information about the Ownership Pattern of New Security Issues

(Percentage)

Period Public Sector Private Sector Period Public Sector Private Sector 1990-91 56.8 43.2 2000-01 23.1 76.9 1991-92 50.0 50.0 2001-02 20.0 80.0 1992-93 7.8 92.2 2002-03 64.7 35.3 1993-94 34.4 65.6 2003-04 46.8 53.2 1994-95 14.2 85.8 2004-05 38.8 61.2 1995-96 30.3 69.7 2005-06 21.5 78.5 1996-97 44.5 55.5 2006-07 5.2 94.8 1997-98 48.7 51.3 2007-08 41.7 58.3 1998-99 45.0 55.0 2008-09 0 100.0 1999-2000 62.8 37.2

2.4 Sectoral Pattern of New Issues

Preponderance of infrastructure sector in new issue market has been characteristic featureduring the post-liberalization era. Thus, it may be seen from Table 2.6 that over 40 percent ofthe capital was raised in the infrastructure, resonating well with current national priorities.Financial services was another significant participant in the new issue market. The IT industry-driver of export revenues raised only 10.7 percent which is a reflection of the fact that theindustry is now in the stable growth phase and internal generation is adequate to meet thecapital requirements.

Another revealing point that can be noted from the table is the niggardly low share of thepharma and biotech sector. Given the strategic importance of bio-sector in future developmentof the country, it would be pertinent to make perspicacious analysis of the factors contributingto low share of this segment.



Notes Table 2.6

Industry No. of firms Sum Raised ( crore)` % of Total

IT & ITES 28 72400 10.7 Financial Services 21 216700 25.0 Infrastructure 39 370200 42.7 Pharmaceuticals & Biotechnology 9 11700 1.3 Telecom & Media 28 72500 8.4 Manufacturing 40 50100 5.8 Consumer goods & services 14 37900 4.4 Miscellaneous 13 15400 1.8 Total 192 867400 100.0

Source: Based on the data for period January 1999-March 2007.

2.5 Mode of Distribution of New Issues

In India, methods commonly employed by companies to raise funds from the market are pureprospectus, offer for sale, private placement, rights issues, over-the-counter placement andstock option. In 1995, the SEBI introduced the concept of book building. Similarly, the SEBIintroduced since September, 1995 compulsory 'market making' on the exchanges in the case ofpublic issues below ` 5 crore.

Table 2.7 embodies information about mobilization of funds by Indian companies throughprospectus and rights and private placement. It may be noted from the table that Indian corporatesector relies heavily on domestic private placement market, obviously to derive certainadvantages like lower transaction costs limited disclosure requirements in the offer documentsand mobilization of funds in a shorter time frame. Thus, in 1999-2000, private placement accountedfor 89 percent of total resources mobilized during the year. However, in recent years, the pace ofgrowth of the private placement has slackened leading to drop in the share of private placementto 61 percent of the total resources garnered during 2007-08. The dwindling trend in privateplacement has been due to the bullish state of economy and secondary market, which made theinvesting community responsive to public issues.

Table 2.7: Mobilization of funds by Indian companies throughProspectus and rights and Private Placement

(Percentage) 1999-2000 2000-01 2004-05 2005-06 2006-07 2007-08 2008-09 A. Prospectus and Rights 11.0 8.7 21.1 11.0 22.2 39.0 13.9 B. Private Placement 89.0 91.3 78.9 89.0 77.8 61.0 86.1 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0

The bulk of resources from the private placement market has been mobilized by private sectorentities – both financial and non-financial. Within the financial intermediaries groups, banks(both public and private sectors) mobilized predominant share of resources.

Did u know? As regards subscription to the public issues, private sector companies havebeen found contributing major proportion to the public offerings, accounting for overthree-fourths of the total issues offered through prospectus and rights issues during 2007-08.



NotesDuring 2008-09, over 90 percent of the resources was garnered through private placement andthe balance (7%) was mobilized through Initial Public Offerings (IPOs). However, the domesticprivate placement, which has emerged as a major alternative source of funding for the Indiancorporate sector in the recent years, witnessed a slowdown during the period due to adversecapital market conditions. Mobilization of resources through private placement was lowerduring 2008-09 than in 2007-08.

Despite tremendous progress made in Indian primary market during the post-liberalizationperiod, size of the market remains much smaller than many advanced economies such as HongKong, Australia, the UK, the US and Singapore, as also emerging market economies such asThailand, Malaysia, Brazil and the Philippines (Figure 2.1).

Figure 2.1

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Aus

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Sing

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UK

Thai

land

Mal

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US

Braz

il

Philip

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Indi

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Arg

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a

Mex

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20

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10

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21.6

4.7

2.3

2.1

1.5

4.7

1.4

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0.8

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4

0.1

Task How far have the various policy measures taken by the government impacted theworking of the new issue market in India?

Self Assessment

Fill in the blanks:

5. During 1994-95 when the primary market was in its initial phase, equity shares accountedfor ............................... of the total resources mobilized.

6. Debt instruments have a redemption period of ............................... years.

7. In 1999-2000, the average size of IPOs was ` 100 and in 2006-06, it was `...............................

8. In financial inter mediariaes group, ............................... mobilized predominant shares ofresources.

2.6 Summary

The new issue market in India until the pre-liberalization period remained undevelopedand lopsided in terms of quantum and kinds of new issues, participation of agencies innew issue activity and investors' apathy towards new security issues. However, the



Notes government undertook a range of measures during the post-liberalization period to revup new issue market. Consequent upon these measures, the new issue market in Indiawitnessed phenomenal changes, both quantitatively and qualitatively, increasing depthand sophistication of the operations of the market as also resilience of the market to copewith the new economic challenges.

Although the Indian new issue market compares well with other emerging economies interms of sophisticated market design of equity market, widespread retail participationand liquidity, participation of FIIs, mobilization of funds through Euro issues, the growthof the debt and equity markets remains low and largely skewed in comparison to the U.S.,Malaysia and South Korea, indicating immense latent potential. Further, the new issuemarket of the country continues to be shallow. Despite inflation, only 2 percent of Indianhousehold savings are invested in the market as against 20 percent in developed economiesand about 51 percent in the US.

A host of factors has stonewalled the full-fledged growth of the new issue market of thecountry. One such factor is inadequate disclosures of information needed by the investorsto make informed decisions regarding investment in new offerings. Despite the SEBI'sclear directives in this regard, Indian corporates are mostly indifferent in supplying therequired details. This has ostensibly eroded the confidence of the investing community.

Overpricing of issues is another pernicious weakness of the new issue market in Indiaresponsible for its stymied development. This created problem for the holders to exitfrom the market. The major concern for the issuing companies at present is to fix the rightprice of the issue. In fact, price discovery price is not perfect because of conflict of interests.At present, a Dutch auction process for the institutional bidders, where the price band isdecided before the bidding begins, is followed. The French auction process works on theprinciple of "Winner takes all". This follows a top-down approach where the highestbidder gets the first allocation, followed by the second highest bidder and so on. TheFrench method can be used to determine the price offered to retail investors who could beallotted shares at the lowest auction price or the average price. However, merchant bankersdo not seem to like the idea. With proportionate allocation, a French auction does notmake sense as there is no incentive for the institutional buyers. In a proportionate allocation,irrespective of the number of shares or the price one bids for, any institutional biddersthat make the cutoff receive an equal number of shares among each other. The SEBI isattempting to find alternatives to improve the pricing process.

High transaction costs, that drive companies to other avenues for mopping up capital,have also hampered the growth of the market.

Due to the latest global financial meltdown, the new issue market has suffered grievouslywith investors' confidence at its lowest ebb. To rev up the new issue market and sustain itsgrowth, it would be the much-needed measure to restore investors' confidence. For thispurpose, it is necessary for the SEBI to protect the investors' interests by making listingrequirements more stringent in phases so as to discourage the participation of unhealthycompanies in the new issue activity, installing an efficient institutional arrangement, anddirecting the companies to adhere strictly codes of corporate governance.

It will also be useful to offer a mechanism of safety net/exit option on new issues to retailinvestors so that the shares at the issue price of the price of a share drops below a certainlevel within a certain specified time. This will, besides exuding confidence among theinvestors, induce the market to move to a more realistic pricing.

Market making spread should be made compulsory at least for a period of 6 to 12 monthsfrom the date of listing. This would go a long way in improving liquidity of the scrips.Issuing companies and the syndicates should be mandated to sell the IPOs. Making adequate



Notescredit available to market makers would help ensure more active participation in thesecondary market. They must be allowed to lend against shares.

2.7 Keywords

Financial institutions: Provide a variety of financial products and services to fulfil the variedneeds of the commercial sector.

Money market: Is a market for short-term funds and covers money and financial assets that areclose substitutes for money.

Primary market of a country renders three major services: investigating and processing ofproposals for new issues, underwriting of new security issues and distribution of new securitiesto ultimate investors.

Secondary market is a market where the sale of previously issued securities takes place.


1. What were the primary reasons for undeveloped new issue market in India during thepre-liberalization period?

2. Discuss, in brief, various measures undertaken by the government and the RBI to developnew market in India.

3. Critically assess the performance of new issue market in India during the post-liberalizationperiod.

4. What were the main reasons for the reforms in the Indian financial market?

5. Discuss the mode of distribution of new issues.

6. "Overpricing of issues is another pernicious weakness of the new issue market in Indiaresponsible for its stymied development." Comment.

7. What role has the public sector played in new issue market in India?

8. What measures would you suggest to further strengthen the new issue market in India?

9. Discuss the objectives of Financial Market Reforms.

10. What are the various measures taken towards the growth of new issue market?

Answere to Self Assessment

1. Partially Convertilde Debenture

2. Global Depository Receipt

3. Foreign Currency convertible Bonds

4. Non-Convertible Debentures

5. 73%

6. 7

7. ` 700

8. Banks



Notes

Contd...


Books RBI, Annual Reports, 2008-09

Business Today, September 21, 2008

Business Times, October 28, 2008

Business Standard, August 21, 2009

Business Standard, March 31, 2010

RBI, Annual Reports, 2004-05 and 2007-2008

RBI, Annual Reports, Op.cit.

Business Line, September 21, 2007

Caselet Financial Reforms and Industrial Sector in India

Sushil Khanna

Indian financial sector reforms have failed to achieve their goal of making the sectormore efficient, and there has been a hardening of interest rates 'instead of the cheapercredit that was promised. These reforms have had disastrous effects on the industrialsector leaving Indian firms vulnerable to the foreign competitor. While MNCs have beenallowed to bring in funds, institutional long-term finance for Indian firms has been curtailed.

The economic reforms in India, initiated in 1991, were based on the premise that macro-economic crisis was a result of 'micro-economic' inefficiencies that distort the structure ofincentives to producers [Bhagawati and Srinivasan 1993]. After a short period of IMF style'stabilisation', with the usual package of devaluation, temporary import compression andfiscal and monetary contraction accompanied by a sharp increase in the interest rates inthe economy, the main focus of the reforms programme has been confined to what isknown as 'structural adjustment'.

The deregulation of the industrial and financial sectors has occupied the pride of place inIndia's structural adjustment programme (SAP). The financial reforms programme set inmotion, follows the well known path of deregulating capital markets and banks, interestrates, with drawing directed credit and subsidies, and encouraging stricter incomerecognition norms and integrating the domestic financial markets with global financialflows, in conformity with the 'Washington consensus'.

Similarly, the major objective of the 'Statement of Industrial Policy 1991', is the 'dismantlingof the regulatory system …(to facilitate) increasing competitiveness for the benefit of thecommon man" [Gol 1991b]. This was sought to be achieved through wholesale abolitionof industrial licensing regime and major amendments to Monopolies and RestrictiveTrade Practices Act (MRTP). The amendments to the latter have specially been far reaching.Thus, the new policy regime abolishes "pre-investment scrutiny of investment decisionsby the so-called MRTP companies…and for prior approval of central government forexpansion, establishment of new undertaking, mergers, amalgamation and takeover" ofother firms. Moreover, the list of industries reserved for public sector were reduced from



Notes17 to six. In addition, private sector participation was allowed even in many industriesreserved for small firms and public sector, and access to foreign technology was makemuch easier [Gol 1993]. The foreign investment restrictions were largely abolished withmajority ownership for foreign investors in most industries, including industries hithertoreserved for public sector and now open to the Indian private sector. The new industrialpolicy was combined with reduction in tariff barriers and elimination of quotas in theimport policy.

That the old industrial licensing regime was flawed and unable to achieve its statedobjectives is now widely accepted. That the system of licensing was used arbitrarily and tostrengthen the stranglehold of a small group of business houses and foreign firms wasdemonstrated by the enquiry into the system by Dutt Committee in the early 1970s [ILPIC1969]. That the system resulted in rent-seeking behaviour from the private entrepreneursand political elite has been the accepted paradigm amongst a number of economists[Ahluwalia 1985].

This paper is an exploratory attempt at tracing the crucial link between the financial sectorand the industrial sector in India, both of which have been in the throes of restructuringdue to far reaching and sometimes ill-conceived attempts at deregulation during the lastseven years. It is grounded in the firm belief that the financial sector has no role other thanto channelise domestic (and where applicable, foreign) savings to the entrepreneurs andmanagers in the real sectors of the form level response to these changes in the policy andregulatory regime. It seeks to explain the turmoil and the crisis in the Indian corporatesector to among other things, the changes in the financial sector and the macro-economicpolicies of the central bank to shocks provided to the economy from large cross borderfinancial flows. Section I discusses the financial sector before and Section II after thereforms. Section III discusses industrial sector reforms and Section IV and V examine firmlevel response to internal and external deregulation of the industrial sector. Section VIseeks to draw some conclusions based on the interaction between the financial and theindustrial sectors.

Reforms in Theory

Financial Sector

That the financial markets are markedly different from other markets and that marketfailures are likely to be pervasive in these markets has been the received wisdom for sometime [Stiglitz: 1993]. The specific characteristics of the financial markets require governmentintervention, including the kind that was practised in India during the last four decades.This intervention helped raised investment and savings rate in Indian economy andsupported the strategy of industrial growth.

Indian financial sector experienced rapid growth and deepening during the first fourdecades of economic development in India. India pioneered the concept of developmentbanking to provide long-term finance to long gestation industrial projects, often atmarginally subsidised rates of interest. Given the fact that capital markets in India weresmall and underdeveloped, these development financial institutions (along with state-owned insurance firms) helped to develop and deepen the capital market through theirunderwriting activity. The nationalisation of the banks in 1969 and the subsequent impetusgiven to branch expansion, especially in small towns and semi-urban and rural areas,fostered the banking habit and accelerated the monetisation of the economy [Ghosh 1979].

The critics of state i

Indian Financial System - LPU Distance Education (LPUDE)...Unit 7: Depositories and Custodians 117 Unit 8: Financial Institutions 140 Unit 9: Commercial Banking Services 183 Unit 10:

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